Managerial Miscalibration

Graham and Harvey are well known for their CFO survey of the equity risk premium. In this paper, they test whether these executives are miscalibrated, i.e. the distribution of their expectations is not correct. They use a unique panel that includes over 12,500 probability distributions of future stock market returns collected from top financial executives over nearly a decade. They find that executives are severely miscalibrated: realized market returns are within the executives’ 80% confidence intervals only 33% of the time. These executives seem therefore to be overconfident in their views. They show that miscalibration improves following poor market performance periods because forecasters are influenced by extreme negative past returns. Poor returns are salient events that seem to influence these executives. They also find that the degree of miscalibration is strongly correlated with the confidence interval that executives provide to their own-firm project returns. Finally, executives’ miscalibration is correlated with their own-firms’ level of investment.

This is an interesting paper that shows that the risk premium is very difficult to forecast even by professional executives and seems to cast doubt on the efficient market hypothesis since their expectations seem to be systematically miscalibrated and therefore wrong. This is also a cautionary tale for not relying on surveys to forecast macro and financial variables, even when the participants are sophisticated executives. At the same time, their forecasts can guide their investment decisions; public policy makers should take note and provide better public forecasts to complement the private miscalibrated forecasts.

A Series of Unfortunate Events

Referee Finance Team
Financial Crisis

A Series of Unfortunate Events:Common Sequencing Patterns in Financial Crises

In this lecture, Carmen Reinhart identifies the common patterns in boom-bust cycles. She takes a historical approach and use international comparisons. She documents the severity of the recent financial crisis and its impact on financial markets and international trade using a global crisis index (banking, currency and inflation composite, BCDI Index, calculated for 66 countries during the 1900-2010 period). She then attempts to indicate where the economy stands in the post-crisis environment by focusing on the housing and labor markets. The last part of the paper discusses the common causes of the crisis and what makes it worse than the past crises, the increase in public debt in all developed economies and the effect of financial repression.

You can follow his lecture part I here. You can access live streaming of the lecture here.

The Leverage Cycle

Melchior
Financial Crisis

The Leverage Cycle by John Geanakoplos (Yale University)

In this very important article from 2009, John Geanakoplos describes his theory of the leverage cycle that explains the booms and busts caused by time-varying leverage.

According to the author

"The theory typically ignores the possibility of default (and thus the need for collateral), or else fixes the leverage as a constant, allowing the equation to predict the interest rate. Yet variation in leverage has a huge impact on the price of assets, contributing to economic bubbles and busts. This is because for many assets there is a class of buyer for whom the asset is more valuable than it is for the rest of the public (standard economic theory, in contrast, assumes that asset prices reflect some fundamental value). These buyers are willing to pay more, perhaps because they are more sophisticated and know better how to hedge their exposure to the assets, or they are more risk tolerant, or they simply like the assets more. If they can get their hands on more money through more highly leveraged borrowing (that is, getting a loan with less collateral), they will spend it on the assets and drive those prices up. If they lose wealth, or lose the ability to borrow, they will buy less, so the asset will fall into more pessimistic hands and be valued less."

Merton and Scholes on Dodd Frank

Referee Finance Team
Financial Crisis

An interesting interview of Robert Merton and Myron Scholes on Dodd Frank.

"Scholes says it is obviously important to understand institutions, but that such understanding is a very “tactical” piece of knowledge. “What you really want to think about is what’s driving it,” he says. Those drivers included government coordination that forced “all the different players to line up together in the same direction.” The government also created a “feedback loop” of guarantees, in which guarantors are guaranteeing some entity that is in turn guaranteeing the guarantor."

" Merton says other problems – such as the need to fix the accounting regime or the forces driving correlation of assets – are more important than the problems with proprietary trading."